Price discovery: it is an important attribute of well functioning capital markets.
Some markets trade with relative ferocity and liquidity with heavily engaged participants actively trying to squeeze the best price out of the market.
After the bell rung to close out the trading day last Friday, 122+ million shares of Tesla’s stock ($TSLA) had traded hands in the previous six and a half hours.
Investors, speculators, professionals, hobbyists, long-term capital, short-term capital, market markers, indexers, and a variety of others all impart their collective knowledge into the market through transactions in TSLA’s stock, ultimately contributing to the $164.31 resting place on Friday April 28th, 2023.
The participants that matter most in this process are those who are most focused on price. Arbitrageurs, active managers and other types of investors who seek to exploit mispricings and/or bring market prices back to an equilibrium. They are often the ones bringing a perspective into the price discovery process, keeping markets efficient and honest.
But not all assets have well-functioning markets. Other markets have weaker price discovery mechanisms.
Real estate is difficult to price because each property and circumstance is unique and may only turnover every few years.
Shares in private companies price through private transactions, often subject to a the dynamics of an English Auction where the price is set by the highest bidder instead of at a market equilibrium. Market data from Hiive, a marketplace for private stock, suggests that companies today are trading on average 40% below the last round, showcasing how wide the gap can be.
But the market with perhaps one of the weakest price discovery mechanisms is also one of the most prominent forms of capital in the world: human capital.
The Pricing Challenges of Human Capital
Human capital can be crudely summed up as the present value of a person’s future earning potential, comprised of four categories:
- Skills – the ability to expertly execute in a specific domain that is developed through practice
- Knowledge – the intellectual capital that is derived through education or action
- Relationships – the social capital that comes from interpersonal connections
- Attitude – the innate (and generally static) traits that influence actions and behaviors
This specific type of capital, albeit quite varied, still trades in a market: the labor market. Unfortunately, today’s labor market has several characteristics that work against price discovery:
- It’s pricing is incredibly opaque: It is a social faux pas to discuss your salary outside of private professional settings and people general adhere to this norm. Companies also keep employee compensation information close to their chest leaving little transparency in the market.
- It trades infrequently: Human capital is typically priced situationally and is subject to many influences that can create marked differences between people of similar stature and skillset. One of the only ways to get an indication of the price of human capital is to interview and collect offers at other firms or by frequently changing jobs, which suggests those who stick with one employer for life may be facing inefficient pricing for their services.
- It is non-fungible: There are about ~4,200 publicly listed U.S. equity securities. By contrast, there are 166.73 million unique individuals in the civilian U.S. labor force. Human capital is subject to the snowflake phenomenon: each person is unique. Unfortunately, that means there are few market ‘comps’ and it is difficult to derive any sort of pricing indications out of recent/similar transactions.
- Returns are hard to measure: For some jobs where inputs are directly linked to outputs (eg. handcrafted goods production), returns can be straightforward. For others, where inputs are blurred with other inputs in influencing the output (eg. have you ever questioned the value added by a consultant and whether they were worth the price?), the expected return on capital can be hard to measure, which makes it difficult to price.
Charting Human Capital
Despite its inefficient price discovery mechanism, like other types of assets, most people invest heavily in their human capital.
We spend increasingly large sums on four-year post secondary degrees as a signal of our expertise, we attend conferences and connect on social media to develop our professional relationships, and we are willing to take unpaid apprenticeships and internships in order to learn directly from those at the top of a given field.
Human capital is an investment of both time and money. But like all assets, the value of human capital is subject to the influences of supply and demand—and therefore, so to is its price.
Imagine for a second that you could price the human capital of a career truck driver. On an individual level, their knowledge and expertise expanded rapidly early in their career as they went through specific training and licensing programs and then slowly compounded higher over time as they gained experience and “specific” knowledge on-the-job. This would be the chart if the truck driver existed in a vacuum: a steady macroenvironmental state.
However, the world is anything but static. Now imagine the same truck driver’s human capital with the added supply/demand influences present in the broader economy. In recent years, last mile delivery rose in importance as global supply chains became interconnected which drove up demand for drivers. Similarly, the lifestyle challenges associated with truck driving relative to white collar work also drove down supply.
These macro factors amplified the value of the truck driver’s human capital… that is, until AI-enabled self-driving vehicles came on the scene.
But it’s not just truck drivers. Over a long enough time frame, advancements in technology [and other environmental forces] will continue to alter the value and price of the human capital associated with most career paths. In fact, seemingly overnight, AI has begun to reshape the ‘stock charts’ associated with many of today’s common white-collar professions.
In today’s dynamic world, it is often said that people who are just entering the workforce will go through multiple careers and tours-of-duty by the time they retire. The visual of this path would look like the chart below with the current price of human capital falling due to macroenvironmental trends, and then rising again as an individual finds a new opportunity and way to create value in the economy.
Given its [potential] volatility, there is benefit to those investing in their human capital to have an outlook on its future price, much like an equities analyst has a view on the future price of a security.
Luckily, some relief on that front is on the way. Price discovery is improving in certain labor markets thanks to several developments:
- “Power to the people”: This phrase is often mentioned by Glassdoor Founder Rich Barton. It is also the foundational logic that powers the company’s strategy of opening up transparency around corporate pay practices. There are a growing number of businesses looking to empower customers with previously illegible sets of data, and company salaries are no different. The anonymity of the internet provides a path to potentially find more pricing signals on the value of human capital (just check out Indeed’s Salary Explorer here).
- ISAs and financializing income streams: The financialization of everything is a trend that has exploded in recent years thanks to some clever fintech innovation. Human capital is also being financialized through some instruments that turn earning potential into a tradable security. At least, that’s one feature of Income Sharing Agreements (ISAs) that allow students to fund their education with a portion of their future earnings (equity) rather than with a standard student loan (debt). These ISAs can swap hands in private markets, providing an indication of price which can rise and fall based on the predicted earning potential of the associated careers of the individuals they are attached to.
- Surveys and internal transparency: Outside of the novel developments above, there are a number of companies that survey the broader environment to try to provide some comparables to employers for setting their compensation levels. This data is starting to be used in a more transparent way by forward thinking companies to help their staff understand what these pay bands look like outside of their current employer and where they currently stand relative to what they could get in the market.
Illegibility Brings Opportunity
While the developments above are helpful, human capital will always be an awkward asset to price.
I like to think of it as degrees of blurriness – as time and health become human capital, and human capital becomes financial capital, and financial capital becomes real capital, there is increasingly clarity around market prices.
The further up the stack, the more legible the price.
But with the world moving so quickly and environmental forces impacting the value of everybody’s skills, knowledge and relationships, we could all benefit from sharpening up some of the blurriness at the bottom of the stack. That is the promise of some of the pricing transparency trends that are unearthing compensation information and putting it in the hands of the individual.
As time goes on, I suspect there is a massive business opportunity around helping people and companies accurately price this once illegible asset.
After all, according to research conducted by OpenAI on the labor market, 80% of US workers are likely to have some of their work tasks impacted by GPT.
Everybody owns some form of human capital. We should all have a vested interest in better understanding its market price.